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After helping fuel decades of development and modernization in emerging economies, economist W. Arthur Lewis’s Nobel Prize-winning growth model can now be applied to the entire world. Unfortunately, what it shows is that we are heading into a period of deep uncertainty and supply-constrained growth.

MILAN – In 1979, W. Arthur Lewis deservedly received the Nobel Prize in economics for his analysis of growth dynamics in developing countries. His conceptual framework has proven invaluable in understanding and guiding structural change in a variety of emerging economies.

The basic idea that Lewis emphasized is that developing countries initially grow by expanding their export sectors, which absorb surplus labor in traditional sectors such as agriculture. As incomes and purchasing power increase, the domestic sectors expand along with the tradable sectors. Productivity and earnings in largely urban, labor-intensive manufacturing sectors tend to be 3-4 times higher than in traditional sectors, so average earnings rise as more people go to work in the industry. expanding export sector. But, as Lewis pointed out, this also means that export-sector wage growth will remain depressed as long as there is surplus labor elsewhere.

Since the availability of labor is not a constraint, the key factor with respect to growth is the level of capital investment, which is needed even in labor-intensive sectors. Returns on such investment depend on competitive conditions in the global economy.

This dynamic can produce surprisingly high growth rates that sometimes continue for years, even decades. But there is a limit: when the surplus labor supply is exhausted, the economy reaches the so-called Lewis turning point. Typically, this will happen before a country has moved out of the lower-middle income range. China, for example, reached its Lewis tipping point 10 to 15 years ago, triggering a major shift in the country’s growth dynamics.

At the Lewis turning point, the opportunity cost of moving more labor from traditional to upgrading sectors is no longer negligible. Wages begin to rise throughout the economy, which means that for growth to continue, it must be driven not by the shifting of labor from low-productivity to higher-productivity sectors, but by increases in productivity. within sectors. Because this transition often fails, the Lewis turning point is when many developing economies fall into the middle-income trap.

Lewis’s growth model is worth reviewing because something similar is happening today. When the global economy began to open up and become more integrated several decades ago, massive amounts of previously unconnected and inaccessible labor and productive capacity in emerging economies moved into the manufacturing and export sectors, producing dramatic results. Manufacturing activity moved from developed countries, and emerging economies’ exports grew faster than the world economy.

Due to the size of relatively low-cost labor in emerging economies (especially China), wage growth in equivalent sectors in advanced economies was moderate, even though activity did not shift to emerging economies . The bargaining power of workers was reduced in developed economies, and the negative pressure on lower and middle income wages spread to non-tradable sectors as displaced labor in manufacturing moved to non-tradable sectors. tradable.

But that process is largely over. Many emerging economies have become middle-income countries, and the global economy no longer has large reserves of low-cost, affordable labor to fuel the above dynamic. Of course, there are reserves of underutilized labor and potential productive capacity, for example in Africa. But these workers are unlikely to enter export-producing sectors fast enough and on a sufficient scale to prolong the pre-tipping point dynamic.

The Lewis turning point will have profound consequences for the global economy. The forces that have been depressing wages and inflation for the past 40 years are receding. A wide range of emerging and developed economies are ageing, reinforcing the trend, and the Covid-19 pandemic has further reduced labor supply in many sectors, possibly permanently. Under these conditions, the four-decade decline in labor income as a share of national income is likely to be reversed, although automation and other rapidly advancing labor-saving technologies may offset this process to some extent.

In short, now that several decades of growth in developing countries have exhausted much of the world’s unused productive capacity, global growth is increasingly constrained, not by demand but by supply and productivity dynamics. . This is not a temporary change.

One clear consequence of this process is that inflationary forces have fundamentally changed. After disappearing or flattening for an extended period, the Phillips curve (which describes an inverse relationship between inflation and unemployment) is likely to make a permanent comeback. Interest rates will rise along with inflationary pressures, which are already forcing major central banks to withdraw liquidity from capital markets.

A highly indebted global economy (the legacy of years of low interest rates) will go through a period of turbulence as debt levels reset for a “back to normal” interest rate environment. Portfolio asset allocations will be adjusted accordingly, ending the prolonged honeymoon during which risky assets outperformed the economy.

Anyone can guess how abruptly this will happen. Specific results are impossible to predict accurately. The global economy’s encounter with the Lewis turning point will be a period of considerable uncertainty, which is to be expected with any tectonic shift.

Many parts of the global economy will experience fundamental regime change. Several decades of growth in emerging economies have fueled a massive increase in middle-income consumers and purchasing power in general, while at the same time eliminating the world’s ultra-low-cost productive capacity.

Of course, there may still be periods of demand-constrained growth, following crises such as the pandemic or future climate shocks. But the underlying pattern will be one of supply- and productivity-constrained growth, because the remaining reservoirs of underutilized productive capacity are simply not large enough to accommodate rising global demand.

Lewis’s work did not focus primarily on the world economy, except insofar as international markets provide the technology and demand needed to drive early-stage export-led growth in developing countries. Nevertheless, his idea that growth patterns change dramatically depending on whether there are accessible untapped productive resources (especially labor) is as relevant as ever.

Applied to the transitions now underway in the global economy, Lewis’s insights imply major changes in growth patterns, the structure of economies, the configuration of global supply chains, and the relative prices of almost everything from goods, services, and labor to merchandise and various asset classes. Equally important, they indicate that this transition will be irreversible.

Navigating the global version of the Lewis turning point will be tricky. Understanding the underlying structural changes is the necessary place to start.

The author

Nobel laureate in economics, he is professor emeritus of economics and former dean of the Graduate School of Business at Stanford University. He is a senior fellow at the Hoover Institution, sits on the Luohan Academy Academic Committee, and co-chairs the Asia Global Institute Advisory Council. He was chairman of the independent Commission on Growth and Development, an international body that from 2006 to 2010 analyzed opportunities for global economic growth, and is the author of The Next Convergence: The Future of Economic Growth in a Multispeed World.

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